IS LM MODEL monetary economic miskhin chapter

economic

1. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Chapter 21
Monetary and
Fiscal Policy in
the ISLM Model

2. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-2
Factors that Shift the IS
Curve
•A change in autonomous factors that is
unrelated to the interest rate
–Changes in autonomous consumer expenditure
–Changes in planned investment spending
unrelated to the interest rate
–Changes in government spending
–Changes in taxes
–Changes in net exports unrelated to the
interest rate

3. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-3
FIGURE 1 Shift in the IS Curve

4. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-4
Factors that Shift the LM
Curve
•Changes in the money supply
•Autonomous changes in money demand

5. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-5
FIGURE 2 Shift in the LM Curve from an
Increase in the Money Supply

6. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-6
FIGURE 3 Shift in the LM Curve
When Money Demand Increases

7. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-7
Response to a Change in
Monetary Policy
•An increase in the money supply creates an
excess supply of money
•The interest rate declines
•Investment spending and net exports rise
•Aggregate demand rises
•Aggregate output rises
•The excess supply of money is eliminated
•Aggregate output is positively related to the
money supply

8. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-8
FIGURE 4 Response of Aggregate Output and
the Interest Rate to an Increase in the Money
Supply

9. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-9
Response to a Change in
Fiscal Policy
•An increase in government spending raises
aggregate demand directly; a decrease in
taxes makes more income available for
spending
•The increase in aggregate demand cause
aggregate output to rise
•A higher level of aggregate output increases
the demand for money

10. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-10
Response to a Change in
Fiscal Policy (cont’d)
•The excess demand for money pushes the
interest rate higher
•The rise in the interest rate eliminates the
excess demand for money
•Aggregate output and the interest rate are
positively related to government spending
and negatively related to taxes

11. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-11
FIGURE 5 Response of Aggregate Output and
the Interest Rate to an Expansionary Fiscal
Policy

12. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-12
Monetary versus Fiscal Policy
•Complete crowding out
–Expansionary fiscal policy does not lead to a rise
in output
–Increased government spending increases the
interest rate and ‘crowds out’ investment
spending and net exports
•The less interest-sensitive money demand is,
the more effective monetary policy is
relative to fiscal policy

13. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-13
Summary Table 1 Effects from Factors
That Shift the IS and LM Curves

14. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-14
FIGURE 6 Effectiveness of Monetary and Fiscal
Policy When Money Demand Is Unaffected by the
Interest Rate

15. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-15
Targeting M
s
versus Interest
Rates
•If the IS curve is more unstable (uncertain)
than the LM curve, a M
s
target is preferable
•If the LM curve is more unstable than the IS
curve, an interest-rate target is preferred

16. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-16
FIGURE 7 Money Supply and Interest-Rate
Targets When the IS Curve Is Unstable and the
LM Curve Is Stable

17. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-17
FIGURE 8 Money Supply and Interest-Rate
Targets When the LM Curve Is Unstable and the
IS Curve Is Stable

18. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-18
ISLM Model in the Long Run
•Natural rate level of output (Y
n)
–Rate of output at which the price level has no tendency
to change
•Using real values, so when the price level changes,
the IS curve does not change
•The LM curve is affected by the price level
–As the price level rises, the quantity of money in real
terms falls, and the LM curve shifts to the left until it
reaches Y
n
(long-run monetary neutrality)
•Neither monetary or fiscal policy affects output in
the long run

19. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-19
FIGURE 9 ISLM Model in the Long
Run

20. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-20
FIGURE 10 Deriving the Aggregate
Demand Curve

21. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-21
Deriving the Aggregate
Demand Curve
•Aggregate demand curve: relationship
between the price level and quantity of
aggregate output for which the goods
market and market for money are in
equilibrium
•As the price level increases, output falls.

22. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-22
Shifts in the Aggregate
Demand Curve
•ISLM analysis shows how the equilibrium
level of aggregate output changes for a
given price level
•A change in any factor except the price level,
that causes the IS or LM curve to shift,
causes the aggregate demand curve to shift

23. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-23
FIGURE 11 Shift in the Aggregate Demand
Curve Caused by a Shift in the IS Curve

24. Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
21-24
FIGURE 12 Shift in the Aggregate Demand
Curve Caused by a Shift in the LM Curve